Patient and private investing

At first glance, the phrase private equity has positive connotations. There's something nice about 'private' as opposed to public and 'equity' denotes something of value.

But private equity can be polarising; many associate the industry with aggressive investors who charge high fees, don't disclose what they're doing and destroy jobs and businesses before selling them at a huge profit.

Equity investment comes in various forms. The most common is public equity investing — buying shares in companies listed on exchanges such as the New Zealand stock exchange. These companies can range from large, established businesses with long track records and consistent dividends to new, tiny companies yet to earn a profit.

Then there is private equity investment which can also come in a variety of forms. Entrepreneurs who start their own businesses are essentially private equity investors, as are those who prefer to buy into businesses not listed on a public stock exchange.

The private equity industry generally involves firms that buy stakes in companies, often funded by debt, with the hope of transforming them into better businesses and taking them public or selling them to another company to turn a profit. They attempt to add value by financial engineering (adding debt and introducing financial incentives to perform), governance engineering (replacing management) or operational engineering (cutting costs and increasing revenue).

A lot of money has been made out of private equity investing, perhaps because of its structure.

Most private equity funds raise money from investors for a fixed period, say 5-10 years, promising to yield superior returns as businesses are bought, transformed and then sold by the time the fund is wound up.

Private equity funds don't pay a consistent dividend along the way and, typically, private equity managers earn management fees as well as a hefty profit share when the fund is ultimately closed. Private equity managers are motivated to add as much value as they can, as soon as they can, so they can sell assets and replace them with new businesses on which to work their magic.

Because they buy with an express purpose of selling, private equity investors don't get seduced into wasting time or money on unprofitable activities.

But some say the best days are behind the private equity industry. In recent years, public equity markets have offered decent returns, making private equity seem expensive, opaque and too long-winded.

CalPERS, the largest public pension fund in the US, recently announced it will review its private equity investments (currently comprising 10 per cent of its $US280 billion portfolio) to determine whether better returns might be achieved without the cost and complications of private equity.

The industry is also facing a headwind in the form of unspent capital. The number of private equity funds has mushroomed in recent years (8,407 with net assets of US$6.7 trillion as at October 2015). According to the Wall Street Journal, the unspent capital in these funds stands at US$1.3 trillion.

Where is all that money going to be invested? How will the funds generate decent returns with so many clamouring to buy a limited pool of businesses?

Regardless of the criticism levelled at the industry, one portfolio manager recently noted that virtually all of the wealthiest people on the planet (aside from those who inherited wealth) made their fortune in private equity.

If you want to follow suit, just make sure that you do so with eyes wide open and a strong conviction, because you'll be tying up your money for a long time and paying a hefty price in the hope that the past success of private equity proves repeatable.

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